Andrew Kaip, managing director of mining equity research at BMO Capital Markets, says the stark reality is that the precious metals sector is only part way through a down cycle and that structural issues will result in a fresh phase of consolidation. He adds that the small to intermediate producers will lead the consolidation charge. In this interview with The Gold Report, Kaip suggests some smart business decisions for the mining sector.

The Gold Report: In late November, BMO Chief Economist Doug Porter warned that interest rates could move higher sooner rather than later in 2015. What's your 2015 outlook for gold given that information?

Andrew Kaip: Our 2015 outlook for gold is that it will trade, broadly speaking, where it is today. Our assumption for next year is $1,190 per ounce. Do we look to Doug Porter's view on interest rates rising and that potential? We do. If the market perceives inflation is becoming a concern, we see that as constructive for the gold price.

TGR: You have extensive experience covering junior gold companies. In your time as an analyst did anything prepare you for this cycle investors are witnessing?

AK: When we look at what has changed over the last couple of years, I think that in general BMO Research understood that the direction was changing. Several years ago we began putting out reports cautioning investors that metal prices had downside risk and we were concerned with structural issues in the sector that continue to play out. And while we certainly understood the direction, I don't think any of us fully understood the magnitude of the shift.

TGR: Do you now have a better understanding of where we're headed?

AK: Metal prices have lost roughly one-third of their value compared to where they were in a peak price environment—even more for silver. If we step back and think about a cycle and how a sector moves from bull to bust, I would say we're really part way through the consolidation that takes place when a sector is out of favor and has to deal with structural issues. That's difficult to hear, but I see the gold space moving through a down cycle. We had a good run from 2010 through 2012, but we're now in a consolidation phase, with the risk of lower precious metals prices.

TGR: There have been casualties along the way. What are you telling your team?

AK: We've always been realistic. Our focus over the last two years has been to steer clients toward mining companies that have strong management teams managing quality assets and building them into stronger businesses.

TGR: You suggested earlier that there are structural problems in the precious metals space, especially among the smaller companies. Could you give us some examples that help illustrate your point?

AK: There are a number of issues that we have focused on. The first is that the operating cost structure for a number of companies is not structured for today's metal price environment. We are looking closely at smaller companies and some larger companies to see how they're responding to lower metal prices. They started by cutting discretionary spending, but now companies are looking more closely at sustaining capital in an attempt to reduce their overall cost structure and maintain profitability. But if you take too much sustaining capital out of the business, how is that going to impact the business in two or three years?

TGR: One hot topic on cutting costs is executive compensation. Has it become unrealistic?

AK: In the context of this current market there needs to be a healthy discussion as to what is appropriate compensation for executive teams. In some instances, levels of compensation are significant relative to a company's production. One thing that our clients are telling us is that they would prefer to see the old business model where executive teams had significant ownership of the companies that they were running. They benefited from their success through share price appreciation. Investors want management aligned with their interests.

TGR: Is there a tangible way investors can determine what is reasonable and what's excessive?

AK: If a management team has significant share ownership—an amount at least comparable to their base salaries—then investors should begin to feel comfortable that those individuals are trying to create wealth and make decisions that will benefit all shareholders.

TGR: What is your view on high grading?

AK: The reality of lower metals prices, particularly in the precious metals space, is that companies have to move toward higher grade to maintain profitability. But that comes at the expense of reserve life. We saw that at the beginning of 2014, but our expectation is that we will see further declines in reserves when reserves are restated at the beginning of 2015. For some companies, that's going to precipitate a decline in reserve life to the point where it could become motivation for consolidation. Some of these companies will have to look to acquire smaller companies with new projects in order to maintain their production profile. In fact, some of these companies are going to have to look at consolidation if they are going to continue operating.

TGR: That is going to place greater importance on exploration.

AK: Exploration is an important aspect of regeneration in mining. Consolidation is really a short-term way for these companies to get out of their current predicament. If we take a longer-term view, exploration has been key to companies reinvigorating existing mines by expanding reserve bases over time. We're not seeing exploration at the level we think it needs to be to replenish reserves in today's market. That's why we think consolidation in the short term has the potential to take hold. And that's constructive from an investor standpoint.

This sector needs to go through a consolidation to create stronger mining companies—and consolidation allows companies to grow their reserve bases and operational flexibility. Then we can look toward a future where investors will want to begin investing in exploration companies again for the prospect that they might make impactful discoveries.

TGR: What is consolidation going to look like in 2015?

AK: Consolidation makes for an interesting discussion. For example, David Haughton, our senior precious metals analyst, says that many of the senior producers he covers are not in a position to acquire and that only a handful have a mandate for acquisition. Our view is that we're not really going to see the large mining companies participate in a round of acquisition. Mergers and acquisitions will mostly be the domain of the small to intermediate gold and silver producers.

TGR: Will consolidation come in the form of cash-and-share deals?

AK: Cash is scarce in this sector. If a company is going to make an acquisition, it is going to make an acquisition primarily with shares. One of the biggest questions for junior companies right now is cash. There is an ongoing debate among exploration company management teams: Are shareholders better off in a larger entity that has the means to develop its assets or are shareholders better off sticking it out in the current environment and hoping for better days?

TGR: In other interviews you have suggested that investors should stick to outliers in the gold space. Please describe an Andrew Kaip outlier.

AK: Outliers are those companies that we believe are well run. They have quality assets that can generate cash at current metal prices or lower. They have management teams that are well regarded, are technically strong and make decisions in the best interest of shareholders. Often those management teams are significant investors in their companies, too. That's the combination we're moving toward.

TGR: You provided the basics of your current investment thesis for gold and precious metal equities. Is there anything you would add?

AK: We've been talking to investors about what they want and that is highly leveraged names. We much prefer investors take into consideration financial leverage versus operational leverage. Operational leverage is looking for high-cost miners. If you invest in high-cost miners, you could see a significant return if metal prices rebound rapidly. But we tend to find that the high-cost operators continue to be high-cost operators because once metal prices begin to rise, those high-cost miners have to reinvest capital in their operations because they've been starving them to maintain profitability.

Most of the financial leverage in the gold sector today is long-dated financial leverage. For investors, that's a lower-risk profile because they don't have the prospects of debt renegotiation and uncertainty. Investors are looking at decent quality assets that are hampered in the current market by debt. Once metal prices move higher, investors can add significant value with lower risk.

TGR: Leave us with one thought that precious metals investors can chew on.

AK: One thing that I believe has been forgotten is that smart business decisions by both mining companies and junior exploration companies are at the heart of opportunity for investors in this sector. The sector needs to get back to the key principles of opportunity. One of them is a healthy transactional environment for precious metals companies. That requires acquirers to see that they can make acquisitions that are accretive to their businesses, as well as junior company management teams that see acquisition as part of their business strategy. We've diverged from that. My hope is that we'll move back into an environment where value can be created for shareholders.

TGR: Thank you for your insights, Andrew.

Andrew Kaip is managing director of mining equity research at BMO Capital Markets. Previously, he worked as a mining analyst at Haywood Securities, most recently covering gold and silver junior exploration and mining companies. Prior to that, he served as a project and consulting geologist for more than 10 years. Kaip received his Bachelor of Science in geology from Carleton University and his Master of Science in economic geology from the University of British Columbia and is a professional geologist.

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